Goldstein v. S.E.C.

Decision Date23 June 2006
Docket NumberNo. 04-1434.,04-1434.
PartiesPhillip GOLDSTEIN, et al., Petitioners v. SECURITIES AND EXCHANGE COMMISSION, Respondent.
CourtU.S. Court of Appeals — District of Columbia Circuit

Philip D. Bartz argued the cause for petitioners. With him on the briefs were Cameron Cohick and Gregory E. Keller.

Jacob H. Stillman, Solicitor, Securities & Exchange Commission, argued the cause for respondent. With him on the brief were Giovanni P. Prezioso, General Counsel, Randall W. Quinn, Assistant General Counsel, and Dominick V. Freda, Senior Counsel.

Before: RANDOLPH and GRIFFITH, Circuit Judges, and EDWARDS, Senior Circuit Judge.

Opinion for the Court filed by Circuit Judge RANDOLPH.

RANDOLPH, Circuit Judge.

This is a petition for review of the Securities and Exchange Commission's regulation of "hedge funds" under the Investment Advisers Act of 1940, 15 U.S.C. § 80b-1 et seq. See Registration Under the Advisers Act of Certain Hedge Fund Advisers, 69 Fed.Reg. 72,054 (Dec. 10, 2004) (codified at 17 C.F.R. pts. 275, 279) ("Hedge Fund Rule"). Previously exempt because they had "fewer than fifteen clients," 15 U.S.C. § 80b-3(b)(3), most advisers to hedge funds must now register with the Commission if the funds they advise have fifteen or more "shareholders, limited partners, members, or beneficiaries." 17 C.F.R. § 275.203(b)(3)-2(a). Petitioners Philip Goldstein, an investment advisory firm Goldstein co-owns (Kimball & Winthrop), and Opportunity Partners L.P., a hedge fund in which Kimball & Winthrop is the general partner and investment adviser (collectively "Goldstein") challenge the regulation's equation of "client" with "investor."


"Hedge funds" are notoriously difficult to define. The term appears nowhere in the federal securities laws, and even industry participants do not agree upon a single definition. See, e.g., SEC Roundtable on Hedge Funds (May 13, 2003) (comments of David A. Vaughan), available at (citing fourteen different definitions found in government and industry publications). The term is commonly used as a catch-all for "any pooled investment vehicle that is privately organized, administered by professional investment managers, and not widely available to the public." PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS, HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT 1 (1999) ("Working Group Report"); see also IMPLICATIONS OF THE GROWTH OF HEDGE FUNDS: STAFF REPORT TO THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION 3 (2003) ("Staff Report") (defining "hedge fund" as "an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which is not registered as an investment company under the Investment Company Act").

Hedge funds may be defined more precisely by reference to what they are not. The Investment Company Act of 1940, 15 U.S.C. § 80a-1 et seq., directs the Commission to regulate any issuer of securities that "is or holds itself out as being engaged primarily ... in the business of investing, reinvesting, or trading in securities." Id. § 80a-3(a)(1)(A). Although this definition nominally describes hedge funds, most are exempt from the Investment Company Act's coverage because they have one hundred or fewer beneficial owners and do not offer their securities to the public, id. § 80a-3(c)(1), or because their investors are all "qualified" high net-worth individuals or institutions, id. § 80a-3(c)(7).1 Investment vehicles that remain private and available only to highly sophisticated investors have historically been understood not to present the same dangers to public markets as more widely available investment companies, like mutual funds.2 See Staff Report, supra, at 11-12, 13.

Exemption from regulation under the Investment Company Act allows hedge funds to engage in very different investing behavior than their mutual fund counterparts. While mutual funds, for example, must register with the Commission and disclose their investment positions and financial condition, id. §§ 80a-8, 80a-29, hedge funds typically remain secretive about their positions and strategies, even to their own investors. See Staff Report, supra, at 46-47. The Investment Company Act places significant restrictions on the types of transactions registered investment companies may undertake. Such companies are, for example, foreclosed from trading on margin or engaging in short sales, 15 U.S.C. § 80a-12(a)(1), (3), and must secure shareholder approval to take on significant debt or invest in certain types of assets, such as real estate or commodities, id. § 80a-13(a)(2). These transactions are all core elements of most hedge funds' trading strategies. See Staff Report, supra, at 33-43. "Hedging" transactions, from which the term "hedge fund" developed, see Willa E. Gibson, Is Hedge Fund Regulation Necessary?, 73 TEMP. L. REV. 681, 684-85 & n. 18 (2000), involve taking both long and short positions on debt and equity securities to reduce risk. This is still the most frequently used hedge fund strategy, see Staff Report, supra, at 35, though there are many others. Hedge funds trade in all sorts of assets, from traditional stocks, bonds, and currencies to more exotic financial derivatives and even non-financial assets. See, e.g., Kate Kelly, Creative Financing: Defying the Odds, Hedge Funds Bet Billions on Movies, WALL ST. J., Apr. 29, 2006, at A1. Hedge funds often use leverage to increase their returns.

Another distinctive feature of hedge funds is their management structure. Unlike mutual funds, which must comply with detailed requirements for independent boards of directors, 15 U.S.C. § 80a-10, and whose shareholders must explicitly approve of certain actions, id. § 80a-13, domestic hedge funds are usually structured as limited partnerships to achieve maximum separation of ownership and management. In the typical arrangement, the general partner manages the fund (or several funds) for a fixed fee and a percentage of the gross profits from the fund. The limited partners are passive investors and generally take no part in management activities. See Staff Report, supra, at 9-10, 61.

Hedge fund advisers also had been exempt from regulation under the Investment Advisers Act of 1940, 15 U.S.C. § 80b-1 et seq. ("Advisers Act"), a companion statute to the Investment Company Act, and the statute which primarily concerns us in this case. Enacted by Congress to "substitute a philosophy of full disclosure for the philosophy of caveat emptor" in the investment advisory profession, SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963), the Advisers Act is mainly a registration and anti-fraud statute. Non-exempt "investment advisers" must register with the Commission, 15 U.S.C. § 80b-3, and all advisers are prohibited from engaging in fraudulent or deceptive practices, id. § 80b-6. By keeping a census of advisers, the Commission can better respond to, initiate, and take remedial action on complaints against fraudulent advisers. See id. § 80b-4 (authorizing the Commission to examine registered advisers' records).

Hedge fund general partners meet the definition of "investment adviser" in the Advisers Act. See 15 U.S.C. § 80b-2(11) (defining "investment adviser" as one who "for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities"); Abrahamson v. Fleschner, 568 F.2d 862, 869-71 (2d Cir.1977) (holding that hedge fund general partners are "investment advisers"), overruled in part on other grounds by Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 100 S.Ct. 242, 62 L.Ed.2d 146 (1979). But they usually satisfy the "private adviser exemption" from registration in § 203(b)(3) of the Act, 15 U.S.C. § 80b-3(b)(3). That section exempts "any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under [the Investment Company Act]." Id. As applied to limited partnerships and other entities, the Commission had interpreted this provision to refer to the partnership or entity itself as the adviser's "client." See 17 C.F.R. § 275.203(b)(3)-1. Even the largest hedge fund managers usually ran fewer than fifteen hedge funds and were therefore exempt.

Although the Commission has a history of interest in hedge funds, see Staff Report, supra, at app.A, the current push for regulation had its origins in the failure of Long-Term Capital Management, a Greenwich, Connecticut-based fund that had more than $125 billion in assets under management at its peak. In late 1998, the fund nearly collapsed. Almost all of the country's major financial institutions were put at risk due to their credit exposure to Long-Term, and the president of the Federal Reserve Bank of New York personally intervened to engineer a bailout of the fund in order to avoid a national financial crisis. See generally ROGER LOWENSTEIN, WHEN GENIUS FAILED: THE RISE AND FALL OF LONG-TERM CAPITAL MANAGEMENT (2000).

A joint working group of the major federal financial regulators produced a report recommending regulatory changes to the regime governing hedge funds, and the Commission's staff followed with its own report about the state of hedge fund regulation. Drawing on the conclusions in the Staff Report, the Commission—over the dissent of two of its members—issued the rule under review in December 2004 after notice and comment. The Commission cited three recent shifts in the hedge fund industry to...

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